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When Banks Compete, Students and Taxpayers Win.

Blog Post

April 23, 2007

Colleges and college aid officials have been funneling their students to big banks like Sallie Mae and Citibank in exchange for cash, gifts and in-kind benefits, according to a series of recent public investigations, the most energetic of which is being led by New York State Attorney General Andrew Cuomo.

Thus far, the investigations have resulted in the suspension of 10 higher education officials, including Columbia University's director of financial aid, the issuance of almost 100 subpoenas nationwide, and a series of financial settlements with several colleges and three student loan banks. The colleges have agreed to gift bans and a new code of conduct. The banks will contribute $6.5 million to a financial education fund.

These measures alone are unlikely to get to the heart of the problem, which is that banks don't compete for student business. Instead, they jockey for a spot on colleges' "preferred lender" lists, virtually guaranteeing that colleges will funnel students in the direction of favored lenders, regardless of interest rates. There's no incentive to ensure that students get the best deal.

There is a novel solution that could reduce student loan borrower costs: create a "lendingtree.com" for student loans. It's what economists call a reverse auction: the sellers (banks) bid for the customers' (students') business.

Here's how it would work: The Attorney General would issue a request for proposals from private and nonprofit entities to design an Internet-based reverse auction platform. Students would make known their interest in borrowing a federally guaranteed student loan. Then, lenders would bid for student business according to the percentage rate offered.

Currently, nearly all lenders charge students the maximum interest rate allowed by law. So no student would end up with a worse deal under a reverse auction system.

There's no need to worry about the banks. Thanks to a government subsidy and guarantee against default, student loans are exceptionally profitable for lenders. On the 2005 Fortune 500 list, the nation's largest student loan provider, Sallie Mae, ranked second in profits as a percentage of revenue. (Microsoft ranked 18th.)

So, make no mistake: Banks could offer far cheaper federal loans to students. In fact, one small New York company called MyRichUncle currently offers federal loans at a rate that's a full percentage point lower than Sallie Mae's. For the typical federal student loan borrower with $20,000 in debt, that translates into roughly a $1,000 savings over the life of the loan.

When MyRichUncle approached colleges to get on their preferred lender lists, it was rejected - because it didn't offer schools kickbacks, stock options, call centers or computer software like Sallie Mae's. It just had a cheaper product for students. You'd think that would be almost enough. It is in a real market.

What are we waiting for? Attorney General Cuomo should create a lendingtree.com for student loans now. Make it free of charge to any student and family in the country. And critically, as a condition of future settlements with implicated colleges and universities nationwide, Cuomo should require that they end their current preferred lender practices and instead refer students to this new reverse student loan auction platform.

The result would be cheaper loans for borrowers and fewer opportunities for colleges to compromise their ethics. Colleges shouldn't funnel kids to student loan banks - an effectively functioning market should.